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About Natural Gas

Demand

As an energy source, natural gas can be used in a variety of ways. It can heat homes and businesses, generate electricity, cook food, drive vehicles or serve as an industrial fuel. We can divide consumers into several categories:

  • Population (residential consumption) – private dwellings, apartments.
  • Businesses and non-manufacturing activities (commercial consumption) – hotels, restaurants, wholesale and retail stores, etc.
  • Industry and manufacturing (industrial consumption) – chemical plants, mining and mineral extraction, etc.
  • Power plants (electric power sector) – gas-fired power plants and utility companies in general, whose primary business is to sell electricity and/or heat to the public.
  • Transportation (vehicle fuel consumption) – trucks, cars, container ships and other vehicles that run on natural gas.
  • Other consumption (technical consumption) – include gas used in drilling operations, as a fuel in natural gas processing plants and gas used in the operation of pipelines.

 

 

A very important characteristic of natural gas consumption is its seasonality. Demand peaks in January because of heavy usage for residential and commercial heating. It then weakens during spring and rises again in the summer months of July and August on electrical generation demand driven by air conditioning use. Demand then cools down again in autumn and starts rising again in winter. Spring and autumn are called “shoulder seasons”. In all three cases the demand for natural gas is driven by weather, which is probably a single most important factor determining natural gas consumption.

 

 

The seasonality of natural gas consumption is exhibited in the futures curve, where the highest-priced months of January and February are also the two months with the highest demand.

 

 

It is important to note, however, that weather does not drive all of the demand for natural gas (although, it does drive most of it). In fact, roughly a third of consumption has no seasonal pattern. Therefore, one can also divide demand into two broad categories:

1. Volatile, seasonal demand – weather-related demand (residential & commercial consumers and electric power sector) – 62% of total consumption in 2014.
2. Stable, non-seasonal demand – not directly driven by weather (industrial consumers, vehicle fuel, lease, plant fuel, pipeline & distribution use) – 38% of total consumption in 2014. However, one should note that some of the industrial consumption does have a degree of cyclicality, while the amount of gas used for distribution purposes is closely tied to the aggregate consumption and is therefore partly seasonal as well.

 

 

Over the past five years, the share of stable demand has been gradually rising – specifically, due to increased gas consumption in the industrial sector. Natural gas use in electric generation has also grown as the fuel is considered environmentally friendly and has a high heat content.

 

 

Natural gas is not the only hydrocarbon in the world and is not the only fuel that can be used to generate electricity. There are other substitutes out there and they may have an impact on consumption patterns in different sectors under different market conditions. One sector in which fuel switching occurs most profoundly is electrical generation. There are power plants that can burn both natural gas and coal and utilities may switch between one fuel to another depending on which is more profitable to burn. The spread between two substitute fuels play a key role in driving consumption dynamics. The most obvious substitute of gas in the electric power sector is coal. The graph below shows the spread between natural gas futures and Central Appalachian coal futures. As can be seen from that graph, there is a strong negative correlation between coal-to-gas switching and the spread. Natural gas consumption in the electric power sector rises as gas gets cheaper relative to coal and falls when the opposite occurs.

 

 

However, the cost of fuel is not the only factor determining the economics of fuel switching. Other important factors include: the cost of switching itself (technical cost), taxes, the cost of extra emissions produced by burning a dirtier fuel. In addition, utilities will not switch fuels if it is beneficial for just one day. They will look at the cost of either fuel over a medium to longer time frame to determine which fuel is more beneficial on a BTU basis.

Supply

Natural gas can be found in various geological formations both onshore (for example, in the Rocky Mountains) and offshore (for example, in the Gulf of Mexico). Just like crude oil, natural gas is produced through basic deposit drilling and well system. However, natural gas deposits can have very different geological characteristics and therefore require different production techniques in order to extract it. The industry distinguishes between conventional and unconventional gas.

Conventional gas is trapped in various rock formations, such as carbonates and sandstones that have good porosity and permeability characteristics. It is easy, feasible and economic to produce.

Unconventional gas is more difficult and costly to produce, since it is found in places with more complex geological characteristics, such as coal beds and shale formations. However, recent technological breakthroughs have made unconventional gas supplies (particularly shale) commercially viable and completely changed the natural gas supply picture, especially in North America.

 

 

Indeed, over the last 10 years, natural gas production in the US has increased by 44% (from 18.9 bcf in 2005 to 27.3 bcf in 2014). The output continues to grow in 2015 even despite a dramatic decline in the number of active oil and gas rigs. In fact, rig count has not recorded a single positive annual change since February 2011, indicating massive improvements in productivity.

 

 

Most of US dry shale gas is produced across four geological formations. They are: Marcellus (Pennsylvania and West Virginia), Haynesville (Louisiana and Texas), Eagle Ford (Texas) and Barnett (Texas). Together they account for about 70% of dry shale gas produced in the US. Other notable areas include: Antrim (Michigan, Indiana, Ohio), Bakken (North Dakota), Fayetteville (Arkansas), Niobrara (Wyoming and Colorado), Permian (Texas), Utica (Ohio, Pennsylvania and West Virginia) and Woodford (Oklahoma).

 

 

As already said, productivity has improved markedly, allowing US companies to extract more gas from fewer rigs. Energy Information Agency (EIA) publishes a monthly productivity report and their data is just staggering. According to EIA, average gas productivity across seven regions has increased five-fold over the last eight years. Analysts used to track weekly rig count data as a gauge of future output, but nowadays that data set has become virtually irrelevant. The number of active gas rigs has fallen from 914 in January 2011 to just 223 in May 2015, while average daily production increased more than 20% over the same period.

 

 

It is therefore important to understand that when it comes to natural gas supply, the US is fully self-sufficient. National gas market does not depend on imports from oversees (only an insignificant amount of gas is imported via pipelines from Canada), which makes supply in the market more stable and more predictable. In fact, the US is planning to start exporting LNG this year, which will add to the aggregate demand.

Storage

Producers accumulate natural gas in underground storage facilities for peak demand times. These storage inventories enable local distribution companies to avoid imbalances in the marketplace. For example, during wintertime the demand for natural gas usually exceeds supply as consumers use more gas (and electricity converted from gas) to heat their homes and premises. It therefore becomes necessary to withdraw natural gas from storage during cold periods (peak demand) and inject it into storage during spring, summer and fall months. Indeed, storage inventory has a very strong seasonal cycle (see graph below), which is key to understanding the very nature of the gas market in general.

 

 

Price

In the United States, natural gas futures trade on the New York Mercantile Exchange (NYMEX); they were launched in April 1990. Physical delivery is to a place called Henry Hub in Louisiana. The futures trade in US dollars per million BTUs ($/mmBtu).

Just like for any other commodity on this planet, the balance between supply and demand determines the price. As can be seen from the graph below, natural gas price volatility has been very exciting in the 21st century.

 

 

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